By Dr. James M. Dahle, WCI Founder
[This article about physician retirement ran as one of my monthly columns from MDMag.com. It starts with the depressing news that a safe withdrawal rate is far lower than most investing novices think, and that returns must be adjusted for inflation. It finishes with the good news that most doctors need to replace far less of their pre-retirement income than they might think to have a comfortable retirement.]
When it comes to planning for retirement, there are three concepts that physician investors often misunderstand. Unfortunately, two of these three constitute “bad news” that I hate to deliver to the “patient.”
However, just like in medicine, you have to understand the bad news to plan your life and treatment plans appropriately.
The Bad News for Physician Retirement
The 4% rule
As an investor begins learning about investing for retirement, one of the first concepts they come in to contact with is the idea of a “safe withdrawal rate” (SWR). This is a percentage of their initial portfolio, indexed to inflation, that they can withdraw each year with a very low chance of running out of money in retirement. Many investors (and their advisors) thought this number was as high as 6%, 8%, or, even, 10% before they were disabused of this notion by a study out of Trinity University first published in the 1990s. The most important table from the Trinity Study is Table 2, reproduced below with data updated through 2009.
As you can see, if you want your portfolio to last 30 years, you can’t withdraw 10% of it a year. You can’t even withdraw 6% from a typical 50/50 portfolio and expect it to have better than a 50% chance of lasting 30 years. Experts like to argue about whether the SWR is 3% or 4% or even 4.5%, but that wasn’t really the point of the Trinity Study. The point was that the SWR isn’t 8%.
The implications of this fact are that on the eve of retirement you need a portfolio approximately 25 times as large as your desired annual income from the portfolio. This is far more money than most beginning investors generally think they will need. A million dollars seems like a lot of money, until you realize a portfolio that size can really only support an income of $40,000 per year.
For a physician who has been making $200,000, $300,000 or, even, $400,000 per year, the thought of living on only $40,000 might be downright depressing. If a physician wanted to replace their entire $200,000 income, they would need a $5 million portfolio. In order to achieve that over a 30-year career with a 5% annualized return, they would need to put $73,000 per year toward retirement, or nearly 37% of their income! If they wanted to retire early after 20 years of practice, that number rises to 72% of their income—a nearly impossible figure.
This is bad news indeed.
Returns Must Be Inflation-Adjusted
To make matters worse, many novice investors use nominal return figures when making calculations. While that is probably fine for short time periods, if you are making plans that span several decades (like retirement planning) inflation must be taken into account.
Historically, inflation has averaged around 3% per year. At that rate, $1 million worth of purchasing power today will require $2.4 million in 30 years. If you decided you needed a $2 million portfolio in today’s money to retire in 30 years and estimated your portfolio would earn 8% annualized returns, you might make the erroneous assumption that you only need to save $17,000 per year. However, if you properly take inflation into account, you would adjust that return down for inflation, perhaps to 5%, and realize you actually need to save $29,000 per year.
The Good News
You Need to Replace Much Less of Your Income Than You Thought
If this is the first time you’ve read about the concept of an SWR and the perils of inflation, you might be reaching for the Prozac. Hold off for just a minute while I share one of the few pieces of good news out there for physicians planning for retirement.
Many physicians mistakenly assume they’ll need to replace their entire income with their portfolio. Even if they ask a financial advisor for a rule of thumb, they might be told they will need 70%-80% of their pre-retirement income to comfortably retire. The truth is that the vast majority of doctors will need a MUCH lower percentage of their pre-retirement income to retire comfortably.
For a typical physician who plans well for retirement, their expenses will decrease dramatically by the time they retire. Consider all the expenses you’re paying now that you won’t be paying in retirement:
Now, everyone’s situation is a little different, and a few expenses may even go up (such as greens fees, travel expenses, and healthcare costs), but these pale in comparison to the “biggies,” such as a mortgage, the high tax burden most doctors pay, and retirement savings.
Most physicians who go through this exercise will realize they probably only need 20%-50% of their pre-retirement income in order to have a very comfortable retirement. Things look even nicer once Social Security is taken into account. While Social Security will replace a much lower percentage of a physician’s pre-retirement income compared to a lower earner, a typical doctor can still expect it to replace about 10% of their pre-retirement earnings.
If you put all this together, a physician now earning $300,000 may find that they will have a very comfortable retirement if their portfolio will provide an income of just $100,000. They can achieve this by saving a very reasonable 15% of their income every year for 30 years and earning a 4% after-inflation return on that savings.
A comfortable retirement is within reach for any physician willing to start early, to learn a little about investing, and to be disciplined about saving a reasonable portion of their income each year.
What do you think? Does the 4% rule reflect bad news to you? Did you think you could take out 10% of your portfolio every year? Are you comforted that you don't actually need to replace your entire annual income with your portfolio? Comment below!
[This article was originally published at MDMag.]
No FICA or Medicare taxes withdrawal in retirement.
Less commuting cost.
The 4% SWR is threatened by extremely low (high quality) bond rates. These low rates may last for decades.
Paul Merriman suggests a 4% of remaining portfolio withdrawal rate, rather than a fixed amount. Maybe more withdrawals in good years, tighten your belt in low return years. Total return investing makes more sense than investing for income only. Capital Gains “income” is just as spendable as interest payments.
Maybe File and Suspend Soc. Security and start drawing only if the Market tanks to avoid selling in Bear markets.
A taxable account gives you much more flexibility at retirement.
Keep in mind when considering the threat to the 4% rule that low rates also generally mean low inflation. If inflation were 0%, even if your portfolio had 0% returns it’ll still last 25 years, longer than most people will need it to. The threats to the 4% SWR are wildly overstated. Sure, it might be 3.5%, but it isn’t the 2% a lot of paranoid people are talking about. The key is remaining flexible and monitoring the plan, limiting fixed expenses so you can spend more in good times and less if things aren’t working out.
Bonds are for safety, stocks are for growth. If you need bonds, you need bonds! Going out on the credit curve is way too risky as bonds are meant to be portfolio stabilizers. Any return is gravy.
Docs close to retirement should move toward a 30-40% Stock allocation for the 5 years preceding and 5 years following full retirement. The risk of another 2008 debacle is too great when you have less time to recoup losses.
Rates on Treasuries are essentially zero. Inflation is running say 2%. College tuition inflation 6-7%. You says there is no inflation?
Everyone should read Wm. Bernstein’s book “Deep Risk:How History Informs Portfolio Design” Great insights from a very smart doc.
Geez, I wish I was going to Bogleheads 13. A comprehensive summary of the meeting is in order when you get back.
im not sure what i would learn at a boglehead meeting? Maybe i just dont understand but it would seem to me to primarily be a meeting where people just agree with what they already know. Just to be clear, im in favor of a boglehead approach.
Well if you “need” bonds to feel good about your investments you should get them and take the security and lack of return that they have currently. I use dividend paying stocks instead of bonds. I also spend less than the investments earn in the early years of my retirement and when Medicare kicks in my costs will decrease. Now I have a minimal cost lifestyle since I am happy with simple pleasures.
Mark-
I’m not saying inflation is 0%. The example was discussing a SWR in a situation with 0% inflation. College tuition inflation only matters if you’re paying college tuition. Personal inflation rate is key, but obviously nearly impossible to calculate, much less forecast.
There are lots of different reasons to hold bonds, including return. P2P lending is way out on the credit curve for example, but has had some exceptionally good returns. Treasury returns suck, but they’re not 0%. The current 10 year treasury rate is 2.66%. Even the 5 year is paying 1.42%. It’s not great, and it’s pretty similar to current inflation, but it surely isn’t 0%.
Thanks for the book suggestion. I’ve been meaning to read Bernstein’s newer shorter books but haven’t gotten to any of them yet. I do plan on getting some posts out of Bogleheads 13 and am looking forward to it.
Barry-
Dividend stocks are not bonds. They are very different financial instruments. If you understand that and decide a high equity allocation is right for you, I have no problem with that, but I see far too many people thinking that anything with a high yield is bond-like, and it just isn’t. I also agree with Benjamin Graham that everyone ought to have some bonds in their portfolio.
Dividend stocks correlate closely with Large cap stocks. Value stocks have historically out-performed Growth stocks…could this be the reason why dividend paying stocks seem to do well? However a value stock is not necessarily a high dividend stock. Within the Stock universe, small caps don’t correlate well with value.
WCI, as a parent of three, you will definitely feel the effect of tuition inflation.
Larry Swedroe says a high dividend strategy is a poor Value strategy.
Bernstein recommends TIPS,Foreign stocks, fixed rate mortgages ( and to a much lesser degree; annuities) as hedges as protection against inflation.
I agree that hedging against inflation is very important in a portfolio as it is a serious risk. I suppose I should feel pretty good about the fact that I hold sizable chunks of TIPS, foreign stocks, and unfortunately, fixed rate mortgages.
I agree that tuition inflation is part of my personal inflation, but for many people, it isn’t.